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January 30, 2014

QE Like a Failing Antibiotic: AEI Economist

John Makin explains why good economic news could actually cause the stock market to fall

Stock prices are due for a fall in the first half of 2014, and how incoming Fed chief Janet Yellen decides a very difficult question will heavily influence the fate of the balance of the year, and beyond.

Why this is so emerges from a layered and subtly argued economic outlook by American Enterprise Institute economist John Makin, whose key insight is based on a term few in finance are likely to be familiar with: “endogeneity.”

The concept, which describes an ecosystem with internal causes of change, can most readily be understood in the well-known problem of antibiotics losing their potency as bacteria develop genetic resistance to antibiotic treatment after repeated use.

“Medical science ends up in a race to develop new antibiotics at an accelerated pace, running faster and faster just to stay in place,” says Makin, and the same phenomenon occurs in the economic sphere.

That is because like bacteria, economic actors such as firms and households, respond to predictable rules such as those followed by the Fed to determine interest rates. Or as Makin puts it, “The Fed’s antibiotic — changes in the federal funds rate — is rendered powerless by the anticipatory adaptation to such changes by the households and firms it is trying to impact.”

In normal times, that might not be so problematic, but when quantitative easing became the new “rule” it quickly became “endogenized” such that increasingly larger rounds of monetary stimulus were having diminishing effects over time.

The federal funds rate, which was as high as 5.25% as recently as September 2007, was cut to 2% by September 2008, then just three months later (following the Lehman crisis), to virtually zero, where it has remained.

Firms and households have so adapted to that policy regime that it has been called “the Bernanke put” — a contracted options price putting a floor beyond which the stock market cannot fall.

While the economy continued to lag, more and more rounds of easing were needed to push investors into risk assets, but they had little effect unless the promises were big, such as the Fed’s QE3 bond-buying program.

More recently, the Fed has continued to elongate its timeline for ending monetary stimulus — from an unemployment rate at 7%, to 6.5% and more recently to 6% or lower — to sustain asset prices. But because Fed policy is fully anticipated, the economy has remained largely unresponsive.

Makin argues that the massive response from Washington and the Fed to the Lehman crash and ensuing financial crisis was effective because its vast scope — including the Troubled Asset Relief Program, zero rates and ultimately QE — exceeded expectations and thus became exogenous rather than endogenous; in other words, it was a surprise.

However, the endogenization of sustained Fed support for asset prices has the paradoxical effect of implying a withdrawal of Fed support as the economy improves, as is now seemingly occurring.

And that paradox produces a policy dilemma for the incoming Janet Yellen-Stanley Fischer regime. Either the Fed moderates QE (as it did Wednesday) and stock prices fall (as they did Wednesday), with potentially severe consequences for an economy that is still disinflationary, and thus at risk of deflation; or the Fed develops a new round of QE at the risk of pushing assets into bubble territory, signaling “the birth of the Yellen-Fischer put,” with all the risk that that entails.

Makin soberly concludes:

“It is too soon to tell which scenario will play out, but under either, stock prices will probably fall during the first half of this year. What happens after that is up to the Yellen-Fischer Fed.”

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